Emerging markets: why bother?
- Emerging markets have underperformed their developed peers since mid-2010, leaving many investors in doubt over the value of the asset class. Why might the next decade be any better?
- Many emerging markets countries show good macroeconomic health, have strong companies with low valuations and are experiencing rapid development
- We believe the prospects for improving returns here are better than they have been for some time
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Looming over Kuala Lumpur at an imposing 1,483 feet, the Petronas Towers symbolise the energy and optimism of a nation in its stride. Once the tallest buildings in the world, they were constructed when Malaysia’s economy was booming. As wealth in the country soared, the towers rose.
This story was not uncommon in the 1980s. Economic reforms, favourable trade balances, and privatisation of sleepy state-owned enterprises in many developing economies caught investors’ attention. It was the story of emerging market investing, where earlier-stage economies promised the opportunity of greater returns. And so, in 1987, the MSCI Emerging Market Index (MSCI EM) was born.
Fast forward 35 years and many investors have started questioning whether the emerging markets story should be placed carefully back on the fiction shelf. Why? Because since June 2010, the MSCI World Index (the developed market index) has delivered five times the return of the MSCI EM Index. Investors simply haven’t been rewarded for taking the emerging market risk. So, it’s a valid question: why should you bother with emerging markets?
Perspective is important. Even after this lacklustre decade, emerging markets have still outperformed developed markets since the MSCI EM Index inception. However, as the chart below shows, favour has flipped between the two regions multiple times.
Emerging markets performance relative to developed markets performance
There are books dedicated to explaining these complex periods, but to summarise briefly:
1987–1994 Economic reforms, access to foreign capital and sweeping privatisation attracted an unprecedented level of investment to emerging markets, delivering extreme returns.
MSCI EM Index 599 per cent vs MSCI World Index 80 per cent.
1994–2001 The Tequila Crisis and the Asian Financial Crisis. These were rooted in several threads of mismanagement: excessive domestic lending, high levels of foreign debt, currency mismanagement, current account deficits and significant capital outflows.
MSCI EM Index -49 per cent vs MSCI World Index 67 per cent.
2001–2007 The rise of China: demand for emerging market products and services skyrocketed. Commodity-exporting economies such as Brazil performed very strongly.
MSCI EM Index 526 per cent vs MSCI World Index 107 per cent.
2007–2023 Free money. Following the Global Financial Crisis, developed market central banks reduced interest rates to historic lows. Individuals and companies loaded up on cheap debt, which suited equity markets. With crises in recent memory, emerging markets stayed away from the free lunch.
MSCI EM Index 11 per cent vs MSCI World Index 153 per cent.
These periods should emphasise to us that when the tables turn, it can be painful to miss out. Indeed, it has been painful for emerging market investors to witness the widening of the valuation discount between emerging markets and developed markets over the last decade or so. We should stress that there is more to the argument for emerging markets than low valuations.
Just as striking as the widening discount is the fact that we’ve seen significant capital flow from emerging markets and developed markets for the last decade, chasing better returns. According to peer group data, the weight of emerging markets equities in global portfolios is at around a 10-year low.
We don’t know precisely when the tables will turn, and it would be foolish to guess. But what we can say is that the macro health of emerging market economies looks strong not only relative to history, but also relative to developed market economies.
Poised post pandemic
Most emerging markets didn’t respond to Covid with massive monetary easing like we saw in developed markets. Support packages deployed to help major emerging markets tended to be 10–20 per cent of GDP, compared with well over 50 per cent in developed majors.
Why does this matter? The answer is that it hasn’t caused the same inflation issues in emerging markets, and it has made their readjustment much easier.
Even emerging market economies which experienced high inflation have had the flexibility to act quickly. Brazil is the best example here. It raised rates from 2 to 14 per cent in short order, and inflation is now well under control. Perhaps it has learnt harsh lessons from previous hyper-inflationary periods.
Meanwhile, many developing markets central banks are balancing on a tightrope between interest rate rises and recession. In many ways, emerging market central banks have been the orthodox actors in the world.
The commodity influence
Long run investors in emerging markets will understand the impact of commodity prices on many key emerging market countries, which have proven to be both a help and hindrance in the past. The direction of key commodity prices undoubtedly influences today’s strong macro starting point. Today we think this can be exploited as a ‘help’ for active investors in emerging markets rather than a hindrance.
The global green transition is predicted to lead to huge demand increases for certain commodities by several multiples. These commodities include copper, lithium, cobalt and nickel, used in products such as electric vehicles, renewable power and infrastructure. The great news for emerging market investors is that much of the world’s largest, lowest-cost deposits of these materials are in emerging markets.
Take copper, for example. Demand could increase as much as three times by 2040 according to the International Energy Agency. Despite that, investment into new and maintenance supplies of copper is actually predicted to fall in the coming years, and it takes decades to make a new copper mine operational. This discrepancy should mean rising prices.
High materials prices won’t just be good for miners – it will be good for exporting economies too, especially in many Latin American countries or in Asian markets like Indonesia. When these economies are booming, they become a richer hunting ground for investors.
We’re often asked whether the best way to access emerging markets is to invest in multinationals with revenue exposure to them. For example, recent results posted by luxury goods companies in Europe show the significant influence of China on their businesses.
But, using this as an avenue to access the rise of the emerging market consumer, misses a key opportunity. Directly investing in emerging markets allows the portfolio to be exposed to the rapid catch up occurring across developing markets.
To our mind, there aren’t many better examples of this than in the growth of online business models. Developed markets have enjoyed internet penetration above 75 per cent since 2010, so it’s no surprise that tech stocks such as Amazon, Apple, Google, Meta and Microsoft sit at the top of the MSCI World Index. However, emerging markets have been closing the gap rapidly, with internet penetration doubling in the same period. That means billions of consumers have been brought online, drastically improving the opportunity set for online companies.
As you can see in the chart below, the number of private companies valued at over $1bn rising out of emerging markets has grown considerably in recent years. Many of these are companies with online business models. We’re starting to see some of these evolving and listing on stock markets in their own right.
Internet access has drastically changed the opportunity set in emerging markets, and the IT sector index weight has almost doubled since 2009. Emerging markets often lack legacy infrastructure such as locally accessible superstores, so new technologies are adopted much faster. This ‘leapfrog’ effect means we believe ecommerce penetration will reach much higher levels in emerging markets than the global average.
Ex US Unicorns created in 2021 and 2022
The China conundrum
The giant panda in the room for emerging market investors is, of course, China. Investing in the country over the past few years has been a painful experience. Geopolitics, regulation and extended Covid lockdowns have fuelled the emerging market pessimists’ fire. Investing in the country has undoubtedly become more challenging, but we think it’s instructive to look at the numbers.
China is the world’s second-largest economy, boasting 11 per cent of global market cap, 25 per cent of listed stocks and 23 per cent of big winners across global stock markets (by which we mean 100 per cent total return, in USD, over five years). Despite this, the entire country has a smaller weighting in the MSCI ACWI than just one company – Apple. Is that really right?
We are not eternal bulls on China. We’re not investing in Chinese GDP growth, or the Chinese index as a whole. We are stock pickers, and the simple fact is that we believe China is a rich hunting ground for stock pickers. The country has an ambitious entrepreneurial culture, supported by bold industrial policies and is far too big to ignore.
Are there risks? Yes, of course. But that’s why we need to be selective and not stop our consideration at the risks. There are huge opportunities here too. China already dominates in globally significant industries – batteries, solar and electric vehicles to name a few. Despite the pessimism of many, our suspicion is that China’s relevance to global investors will continue to increase over the next decade.
China plus one?
Who and where we buy things from has come under the microscope since the pandemic. There is an endless number of new buzzwords flying around this trend: ‘deglobalisation’, ‘near-shoring’, ‘friend-shoring’, ‘China plus one’, or even ‘China exit’.
That in itself is often a signal to apply some caution. Again, we must look at the data to understand what this trend means for China and the emerging markets. What it shows is that since the pandemic, nominal exports from the country have been accelerating, not decelerating.
Export index, nominal export value
China has become the world’s factory over the last 20 years, and it will likely take a similar timeframe to replace it. These changes will be driven by economics, not just geopolitics.
Who stands to benefit from this transition? The answer is alternative regions with low-cost labour and competitive advantages such as Vietnam, India, Indonesia and Mexico.
Vietnam has been a success story of the last decade, gaining traction well before this trend hit headlines. It offers similar manufacturing expertise to China at a fraction of the cost. However, it can’t match the scale of China’s labour force.
Conversely, India, now the most populous nation in the world, measures up in size but lacks expertise. Apple, for example has moved 5 per cent of iPhone production there, with suggestions that this could reach 25 per cent soon.
As you might expect, we strongly advocate for active investment in all regions. We mustn’t forget that in 1987, it was Malaysia, not China, that dominated over 30 per cent of the Emerging Markets Index. Back then, China commanded less than 1 per cent, similar to Malaysia’s weighting now. The idea that the index is risk-free is an illusion.
While our clients tend to judge us on long-term relative returns, we are extremely conscious that what matters to their portfolios is long-term absolute returns.
We are not emerging market ‘perma-bulls’ and have not even always been emerging market enthusiasts. But given some of the trends outlined here, we are strongly of the view that the prospects for improving absolute returns look better than they have for some time.
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MSCI Emerging Markets Index
MSCI Emerging Markets Index
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